The EU Is on a Crusade to Make Apple Pay More Taxes. There’s a Bigger Problem It Can’t Fix.

Everyone involved in the European Union’s crusade to make Apple pay more taxes has a reason to be pissed off. The tech giant, livid EU officials say, has dodged more than $14 billion in taxes in Ireland, where its European operations are based. Apple is outraged, obviously—and astoundingly, so is Ireland. American politicians and the U.S. Department of the Treasury, who routinely lambast domestic companies for shifting profits to overseas tax havens, are enraged that the European Union is targeting U.S. firms who have allegedly received sweetheart deals from Ireland and other countries. The politicians are clearly pandering, but the Treasury knows that if Ireland taxes Apple’s profits, that money will effectively come out of its own coffers. So who, amid the uproar, is right?

The conflagration involves three distinct issues that have become mixed up together. The first is tax competition, which can amount to impermissible state aid, depending on how it plays out. The EU is accusing Ireland of giving special tax deals to Apple that are unavailable to other taxpayers. Apple and Ireland disagree, which is part of why Ireland is so angry that it has been ordered to collect an extra $14 billion from Apple.

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Most agree that states should not directly subsidize businesses, and that they should have full control over their own tax systems. In some cases, however, targeted tax breaks can amount to subsidies. The U.S. did something similar a few years back when it gave special tax breaks to exporters; after the World Trade Organization ruled against those breaks, those provisions were replaced with a tax deduction for manufacturing. While EU member states are free to set their own tax rates, the EU has decided they should not compete with each other by offering special deals to companies. The goal is to prevent companies from playing countries off against one another when contemplating where to locate their operations. The claim here is that Ireland offered a special tax deal to Apple so that it would locate in Ireland.

Ireland’s statutory corporate rate is a low 12.5 percent—far lower than its EU counterparts—but Apple has found a way to pay a tiny fraction of that. It is certainly possible that Apple’s tax lawyers have figured how to game the system in a way that others can only dream of, but Occam’s razor and what is almost certain to be a thorough and well-reasoned EU competition report (which will be available as soon as any confidential information is removed) strongly suggest the existence of an improper sweetheart deal.

Finally, there is the question of tax credits, and why the Treasury supports Apple’s attempts to avoid foreign taxes, despite the grumbling that it also appears to avoid U.S. taxes. One of the core principles of international tax is that income should be taxed only once. Where a taxpayer resides in one country but earns income in another, this can get tricky. While the U.S. taxes citizens on their worldwide income, it also offers tax credits for foreign taxes paid. This means that the most that a taxpayer will owe is the U.S. rate, assuming that foreign taxes are lower than U.S. taxes. Put differently, we deduct from U.S. taxes owed any income taxes paid to foreign governments.

While the tax credit regime avoids the deadly sin of double taxation, it means that we effectively subsidize other countries. The more they tax, the less we collect. So, how does this play into the current mess? Although we tax U.S. companies on their worldwide income, there is a key exception for money earned by foreign corporate subsidiaries. Such income is typically not taxed until a dividend is issued to the American parent company. This is the reason American corporations have amassed $2 trillion overseas that they refuse to repatriate. And this is why the Treasury Department is outraged. If Ireland collects $14 billion of taxes from Apple, Apple will simply turn around and use that $14 billion to offset its U.S. tax liability if it brings that money home.

The current kerfuffle is focused primarily on whether Ireland offered Apple a special deal that amounts to a subsidy. However, the far more important question is how to address profit shifting by multinational corporations. Current reform efforts in the U.S. are focused on lowering corporate rates or switching to a territorial system where the U.S. taxes only those profits earned in the U.S., letting other countries tax profits earned within their boundaries. However, the ability to shift profits is something like the black hole at the center of our galaxy. We can fiddle around the edges, but unless we do something drastic about it, it is only a matter of time before it eats everything.

Perhaps the best solution would be to create a formulary system similar to that currently used in the U.S. to allocate income among states. Under such a system, income is distributed to states based on a variety of factors, such as sales, capital, and payroll located within the different states. While companies can affect their taxes by moving equipment and people around, the changes reflect real-world changes and not just paper transactions. However, this solution would require significant international cooperation and coordination—and politically would almost certainly be dead on arrival.